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Fed raises rates again
Another quarter-point hike, with more 'measured' increases likely, but a clear signal on inflation.
March 22, 2005: 4:15 PM EST
By Paul R. La Monica, CNN/Money senior writer
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NEW YORK (CNN/Money) - The Federal Reserve raised short-term interest rates another quarter point Tuesday and said it expected to keep boosting rates at a "measured" pace -- but the central bank put investors on notice that it was growing more concerned about inflation.

The central bank's policy-makers lifted the federal funds rate, an overnight bank lending rate, from 2.5 percent to 2.75 percent, the highest since right after the Sept. 11 attacks in 2001. It was the seventh quarter-point increase since the Fed started raising rates last June to end an era of super-cheap money and start the preemptive battle against inflation.

But while it kept its "measured" language, the Fed also noted a pickup in "pricing power" in recent months, a sign that Fed chairman Alan Greenspan and other policy-makers are worried about record high oil prices and other inflationary pressures. Stocks and bonds fell sharply following the announcement.

The Fed has been using the word "measured" to describe its stance on future rate hikes since last May, and some thought it would drop that term Tuesday due to growing worries about rising oil and other prices taking a toll on the economy in recent months.

The Fed acknowledged some of these pressures in its statement.

"Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident," the central bank said.

But it added that "the rise in energy prices, however, has not notably fed through to core consumer prices." (For the full statement, click here).

Measured with an asterisk?

Steve Van Order, fixed income strategist with institutional firm Calvert Asset Management, said Tuesday's statement was akin to maintaining a measured pace, but with a notable asterisk.

"The Fed managed to keep most of the same buzzwords but gave us the message that this is more hawkish. There is no need to change the pace now but they would raise by a half-point if they had to," Van Order said.

He added that the Fed's mention of energy prices may actually lead some jittery investors to worry more about the possible impact of oil prices, even though the central bank's words might appear to be reassuring.

As such, the reaction on Wall Street was negative.

Stocks prices gave up their gains and fell sharply, and Treasury bond prices fell, pushing the yield on the 10-year note from about 4.48 percent before the Fed's announcement to 4.62 percent afterward, the highest in eight months. Bond yields and prices move in opposite directions.

David Kelly, senior economic advisor with Putnam Investments, agreed that even though the Fed kept "measured" in its statement, he thinks it indicated that it is a little more worried about inflation due to the "pricing power" phrase. Still, he said this doesn't mean the market should worry about more aggressive rate hikes.

"This is a slight move away from the Fed's completely balanced view of the world on inflation but I don't think they will accelerate the pace of tightening," Kelly said. "There is a little more fear of inflation but the fact that the Fed kept measured tells me they are comfortable with the path they are on."

Watching the numbers

To that end, C.T. Urban, senior portfolio manager of Caterpillar Investment Management and manager of the Preferred Short-Term Government Securities fund, said he thinks it's almost a guarantee the Fed will raise rates at its next meeting on May 3 by another quarter-point, as opposed to a half-point.

"There will be no surprises. The Fed can continue to raise rates by a quarter point as long as they believe they are ahead of the inflation curve," Urban said.

According to fed fund futures contracts on the Chicago Board of Trade, traders are still betting on a quarter-point hike in May and another one at the end of the Fed's two-day meeting in late June.

Looking further out, Calvert's Van Order said the Fed is likely to continue raising rates by a quarter point through the rest of the year. If it does that, the fed funds rate would end 2005 at 4.25 percent, a rate that many market observers feel would be the Fed's sought-after "neutral" level that should encourage economic growth but keep inflation at bay.

But the deathwatch on "measured" is likely to accelerate. David Joy, capital markets strategist with American Express Financial Advisors, said the Fed sent a strong signal to the market Tuesday that the term's days are numbered and that inflation is a legitimate risk.

"This is consistent with Greenspan's approach of incrementalism in policy and language. This seems like one step closer, if we get continued data showing upward pressure on prices, to removing measured," Joy said. "Greenspan has succeeded in capturing the market's attention."

This means that every bit of economic data in the next few months will be scrutinized even more closely for hints of inflation. First up is the February consumer price index (CPI) due Wednesday morning. Economists are expecting a 0.2 percent increase in the overall CPI as well as in the core number, which excludes food and energy costs. Economists have often tended to focus more on the core figure.

But Joy thinks the Fed will be closely watching the overall number for signs of inflation. "The persistence of high oil prices can't be lost on the Fed. Consumers have to pay for higher energy even though it's volatile. It is a real cost."

Caterpillar's Urban echoed that sentiment. "Oil is the wild card. If rising energy costs somehow get institutionalized into overall prices, then there is a problem."

For more on investors' reaction to the Fed, click here.

For winners and losers in a rising rate environment, click here.  Top of page


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